The concept of a recession is binary and blunt. All it says is that expectations have flipped from positive to negative growth, at least for two consecutive quarters.
We think the bigger scenario question revolves around the shape of the shock — what we call “shock geometry” — and its structural legacy. What drives the economic impact path of a shock, and where does Covid-19 fit in?
To illustrate, consider how the same shock —the global financial crisis — led to recessions with vastly different progressions and recoveries in three sample countries:
V-shape. In 2008, Canada avoided a banking crisis: Credit continued to flow, and capital formation was not as significantly disrupted. Avoiding a deeper collapse helped keep labor in place and prevented skill atrophy. GDP dropped but substantially climbed back to its pre-crisis path. This is typical of a classic “V-shape” shock, where output is displaced but growth eventually rebounds to its old path.
U-shape. The United States had a markedly different path. Growth dropped precipitously and never rebounded to its pre-crisis path. Note that the growth rate recovered (the slopes are the same), but the gap between the old and new path remains large, representing a one-off damage to the economy’s supply side, and indefinitely lost output. This was driven by a deep banking crisis that disrupted credit intermediation. As the recession dragged on, it did more damage to the labor supply and productivity. The U.S. in 2008 is a classic “U-shape” — a much more costly version than Canada’s V-shape.
L-shape. Greece is the third example and by far the worst shape — not only has the country never recovered its prior output path, but also its growth rate has declined. The distance between old and new path is widening, with lost output continuously growing. This means the crisis has left lasting structural damage to the economy’s supply side. Capital inputs, labor inputs, and productivity are repeatedly damaged. Greece can be seen as an example of L-shape, by far the most pernicious shape.
So, what drives “shock geometry” as shown above? The key determinant is the shock’s ability to damage an economy’s supply side, and more specifically, capital formation. When credit intermediation is disrupted and the capital stock doesn’t grow, recovery is slow, workers exit the workforce, skills are lost, productivity is down. The shock becomes structural.
V, U, L shocks can come in different intensities. A V-shaped path may be shallow or deep. A U-shape may come with a deep drop to a new growth path or a small one.
Chosen excerpts by Job Market Monitor. Read the whole story @ Understanding the Economic Shock of Coronavirus